Magic Formula Stock Review: Vector Group (VGR)

5

Vector Group is structured as a holding company, but the company's business is selling discount cigarette brands in the United States. Their two largest brands are Grand Prix (29% of volume) and Liggett Select (23%), and the company also sells Pyramid, Eve, and USA. Vector Group also owns a 50% stake in Douglas Elliman, a realtor in the New York metropolitan area, but real estate is such a small contributor to operating earnings that it can basically be ignored for the purposes of analysis here.

There are few bullish arguments on the stock, but let's address them anyway. First, Vector occupies probably the most attractive niche of the cigarette business: the discount end. Discount cigarettes have been about the only sector of this market to experience volume growth in the last decade, as premium brands are being priced out of the range of lower income smokers. Also, the 1998 litigation settlements with 46 states require only the 3 largest cigarette makers to pay the costs. Vector's Liggett Group is 5th, and as a byproduct has gained a valuable cost advantage against bigger makers like Altria (MO) and RJ Reynolds (RAI). The "big boys" are handcuffed by these costs if they decide to compete in the deep discount cigarette market, a significant competitive advantage for Vector Group.

The second positive is the dividend. Vector Group currently pays a massive 11.4% yield, and they have maintained such a high payout for several years now. It is unlikely that this dividend is sustainable over a long-term period, as last year it represented 122% of free cash flow. Management has been funding it with debt, a bad idea (I'll discuss financial health later). However, I believe it is more likely than not that a one-year Magic Formula investor would probably be able to collect the full yield, as Vector has been able to sustain operating profits even against some difficult challenges. Dividend investors with a long-term horizon would want to steer clear, though... this is not a yield that is going to hold, and it certainly will not go up over the long term.

So that's the case for the stock... now let's get to the negatives, which dwarf the positives, keep Vector Group far out of the MagicDiligence Top Buys portfolio, and in fact should keep MFI investors out of the stock. First and foremost is the government's shadow war on smoking. Having mostly failed in direct litigation in the 1990's, federal and state governments are now using a more effective stick: excise taxes. In April of this year, the federal excise tax on a carton of cigarettes was raised from $3.90 to $10.07, a crippling 158% increase. Some states tack on as much as an additional $4/carton. In response, Vector had to increase the wholesale price of their cartons by an average of about $7.50. As a result, revenues have spiked significantly (over 60%), but gross margins have plummeted from the low 40% range to the mid-20's. The net effect has been almost break-even - operating profits have been about flat against pre-increase levels.

The problem, though, is the effect going forward. Higher excise taxes hurt discount brands more than premium ones like Marlboro, as discount customers buy based almost solely on price, while premium brands enjoy customer loyalty and are less price-sensitive. When discount cigarettes get more expensive, it is likely that the low-income buyers they attract will buy fewer packs, or look to alternatives like smokeless tobacco. Vector's volume numbers bear this out: last quarter, Liggett Select suffered a 31% decrease in unit volume, while Grand Prix fell 13%. This is quite the conundrum for Vector, as all of their sales are inside the U.S., and cigarette volume growth (and tax freedom) is almost exclusively overseas.

There are other reasons not to like Vector. The balance sheet is aggressive: about $355 million of debt vs. $300 million in cash, with another $142 million in convertible debt derivatives. Interest is covered by operating earnings just 2 times over, well below the 5 times MagicDiligence likes to see as an absolute minimum. As previously mentioned, free cash flow is not sufficient to service the dividend, yet alone debt obligations. Debt and dividend are being financed with... debt. When you combine shaky financial footing with a very unfavorable regulatory environment, it is a recipe for trouble.

Finally, the company is just ugly to analyze. I count no less then 16 non-operating line items in the income statement (for the past 5 years), with a history of restructuring, unconsolidated side-businesses, and confusing financing. Vector does a bizarre 105:100 stock dividend every year. It engages in the completely unrelated business of residential real estate brokering. In short, it is a difficult business to fully understand, and the ability to understand a business is Warren Buffett's #1 requirement for an investment.

With all of these negatives, MagicDiligence recommends MFI investors steer clear of Vector Group and look elsewhere.

Thanks for the write-up, MD. I had VGR show up on a recent screening, but discounted it as soon as I saw the payout ratio numbers that support the dividend. I agree that the div's not sustainable, but I'm a bit more pessimistic. Depending on which way the economy goes over the next 3-6 months, they may not even be able to sustain the current level for a year.